Stocks

Investing in stocks is what most people think of when it comes to investments, and owning shares in good companies with a proven track record can indeed be very profitable. The stock market lends itself both to long-term investments and trading – short-term ownership of stocks whose price go up or down in days or weeks. The price of a stock going down does not sound like a great investment opportunity, but through “short selling” it can be quite rewarding for the knowledgeable investor.

Stock Market Chart

The FTSE is the most popular stock market index in the UK. Note that you can edit the ticker symbol to make this chart show whatever stock or index you wish.

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How to Get Access to the Stock Market

With hundreds of millions of traders worldwide participating in stock exchanges around the world, stock brokerages represent the access point to the stock market. So the first step in starting the journey of trading stocks is by opening an account with a stock broker.

There are two types of stock brokers operating in the market today. We have:

a)    Full-service brokers who provide an array of value-added services in addition to the conventional ‘buy and sell for me’ services rendered by brokers. They provide investment advice, portfolio management and sometimes, privileged news delivery services regarding virgin investment opportunities and market moving information. Their services are quite pricey, and for this reason, only those with a sizeable amount of cash can afford their services. These brokers also have a minimum benchmark for account opening balance, usually starting with thousands of dollars.

b)    Discount brokerages offer stripped-down brokerage services. The unique selling proposition of discount brokerages as pioneered by Charles Schwab and others, is the very low brokerage fees that range from $4.95 to $9.95 per trade, irrespective of the number of shares being traded. However, this puts the onus of the extra services such as investment research solely in the hands of the trader. Discount brokerages allow traders open cash accounts for as low as $500 and $2,000 for cash/margin (leveraged) accounts. There are many discount brokerages and a search for them on the internet search engines will yield a plethora of names.

Requirements for Stock Trading

Having capital to trade is only one of the requirements. Traders must present documents to prove their identity and also to show where they live. These requirements became necessary after the September 11, 2001 attacks showed a lot of terrorist money being moved by third party/proxy accounts. So the fight against money laundering and financing if terrorism has been moved a notch by requiring all traders to be identified as the bonafide owners of the accounts that they trade with, and that the money they use for trading does not come from illegal sources. To this end, traders must present a drivers’ license/international passport/national ID card as proof of identity, AND a bank statement/utility bill as proof of residence. Some countries have also gone a step further to require that brokers operating citizens-only brokerages collect information concerning taxation status and residency status.

Furthermore, a trader will need to equip himself with the tools of the trade. A computer/smartphone and access to the internet are must-haves for every stock trader. Traders must also have an acceptable means of depositing funds and withdrawing funds from the stock trading account. A credit/debit card, domiciliary account for wire transfers or an e-wallet account such as Skrill are acceptable methods of transaction.

How Stocks are Traded

A stock can be traded by a long position, aiming to profit when the stock appreciates, and to a restricted extent, traded by short-selling the stock with the aim of profiting from a drop in price. Various methods of analysis are used to predict the movement of the asset.

In a nutshell, this is what a beginner who wants to trade stocks needs to know about the stock market. The actual business of buying and selling stocks is outside the scope of this article, but the information is accessible on other sections of this site.

Fundamental Stock Analysis

Fundamental analysis in stock trading concerns the intrinsic value of a stock in relation to its present and future valuation by the market. Questions a trader must ponder are:

1. What is the present market value of a stock in relation to a rational and objective valuation of the company’s performance and prospects?
2. Is the present price of a stock representative of its actual value? In other words, is a stock presently undervalued, truly valued or overvalued on the basis of its present market price?
3. Will a stock’s price correct itself to match its intrinsic value?

So the whole idea of using fundamental analysis is to determine the relationship of the present price of a stock and its intrinsic value, determine if the price matches that intrinsic value, and determine when the price will correct itself to match the intrinsic value depending on the circumstances and news items surrounding the stock in question.

The following data are used by traders when deciding on whether it is worthwhile to invest in a stock or not.

Earnings Reports

The earnings season is a period which the markets take very seriously and is one that traders and investors look forward to. This is when the earnings reports are released. The earnings report not only tells investors how much money a company has made or lost, but also gives traders the following information:

• Earnings per share
• Price earning ratio (P/E ratio)
• Net income
• Net sales

The price-earnings ratio is especially important in measuring the valuation of a company. The lower the P/E ratio of a company, potentially the better the valuation of that company. A very practical way of looking at a company’s valuation using the P/E ratio is to compare it with that of other companies listed in the same sector.

Earnings reports are released every three months, i.e. every quarter. They enable investors and shareholders to gauge the financial status of the companies in which they have investments in, and also in companies in which they may have an interest in investing in. The numbers seen in the earnings are not considered on their own, but are rather weighed against past numbers to see if there is improvement in financial performance or a decline. For instance, a company may release a report stipulating that they recorded a loss, but if the loss was much less than in previous quarters (as was with Blackberry’s Q2 2012 report), investors will interpret this as a sign of changing fortunes and we will see demand on the stock. On the other hand, if profits declared miss estimates (as was seen in Google’s and Apple’s Q3 2012 reports), demand will drop as investors offload the stocks of these companies. Google’s stock fell 10% on the day its disappointing Q3 report was released.

So investors can on the basis of the earnings reports, decide whether to pull out from a company, or put money into a company or even increase the existing stake that they have in the company, and these factors will affect the share price of the company.

Introduction of a New Product

Certain companies are known by their products. Talk of Apple and immediately people think about the iPhone, iPad and iPods. No one really associates Apple with their TVs or with any of their other products. The iPhone and iPad are the flagship products of Apple as a result of the revolution these products created in the world. They changed the way we make calls and use the internet. As such, anytime an upgraded iPhone or iPad comes up in the market, we see sales going through the roof and investors scrambling for the shares of Apple as a result of the perceived valuation of the company in the near future. The Apple story is a clear example of how the introduction of a new product that creates a human revolution can change the financial outlook of that company, and is so doing, determines its valuation as perceived by investors.

Mergers and Acquisition

Mergers and acquisitions have the same valuation effect on a company’s stock. If a struggling company is acquired by a much more powerful company, there will be an improved valuation on the shares of the acquired company. On the other hand, a merger between a strong company and an extraordinarily weak company can have a negative valuation on the shares of the former.

Government Policy

A government policy can radically change the perception of stocks in a particular sector, and increase the valuation and intrinsic values of the affected companies. When the US Supreme Court upheld most of the provisions of the Affordable Care Act of 2012 (Obamacare), the stocks of Medicaid HMOs such as Molina, Amerigroup and Centene soared while those of health insurers dropped because of the income expectations that the law would have on both sets of companies. Health insurers would incur more costs by covering people with certain preexisting conditions, as well as compete with state-based insurance exchanges for clients, which could negatively impact their finances. On the other hand, Medicaid HMOs would be able to make more money from the increased number of clients in the system. This is just one example of how a government policy could change the valuation of a company.

It will take some practice to fully understand how to use these parameters in fundamental analysis. The trader can practice this by looking at historical instances and applying them to present-day situations on a stock trading demo account in order to fully master the technique of trading stocks with fundamental analysis.

Assessing Stocks for Investment

Stock investment is serious business. It involves putting in money into an asset with the expectation that returns on that investment will be achieved. Generally speaking, the positions that investors will hold in stocks are “long positions”, which means that traders will be looking for price appreciation in order to make money from those positions.

So in assessing stocks for investment, it is necessary to look at the factors that will promote price appreciation.

Prerequisites for Stock Assessment

The first step in assessing stocks for investment is to determine the investment goals. What forms investment goals?

• Expected profit/returns on investment
• Duration of investment (especially when trading with leveraged instruments)
• Risk appetite of the trader
• Risk profile for the stock

The expected return on a stock investment provides a benchmark that traders can use to determine what and where they should be putting their money. For instance, if a trader hopes to make 40% returns on his investment after one year, and there are sectors of the stock market that deliver returns of an average of 50% as opposed to other sectors that deliver only 5%, the trader is better off putting his money on stocks in the higher return sector.

This takes us to the next point, which is the trader’s risk appetite. Stocks that deliver higher returns are by nature, more risky than those which deliver low returns. Stocks move upwards and downwards depending on the market situation, and a stock’s upward movement also correlates with its downward movement. A stock that has movements of up to 20% in a single trading session, can either deliver either a 20% profit, or a 20% loss. Another stock which may only move 3%, means that it can deliver a profit or loss of 3%. A trader who is able to take on large movements on his account without losing sleep, should be able to put money in the higher yielding stock.  Some traders may not be aware of their risk appetite, and may need professional guidance on this. For instance, traders closer to retirement are not supposed to engage in risky stock investments.

Before investing in a stock, the trader should look out for the risk profile of the stock to be invested in. Stocks listed in the micro-cap sector are generally more volatile than blue chip stocks, and while micro-cap stocks can deliver good profits, their volatility means that it is easier to lose money with them than with the blue-chips.

In a nutshell, here are the factors that are generally used in assessing which stock to invest in at a particular time.

Finally, traders should be very clear about how long they want to be in a stock. Short term traders are in it for the money, long term traders are in it for the inherent value of the stock. The trading mindset and methodology of these two classes of traders is very different.

Assessing Stocks: What to Look Out For

Now that we know what investors should consider when deciding on how to carry out stock investment, what are the core factors that affect the price of stocks? These parameters listed below are the core factors to consider because they directly impact share prices.

Earnings Reports: The earnings report constitutes the major factor that traders consider when taking position in a stock, especially when those traders are traders with a short term view on the market. Every company is in business for one thing only: to make money. If a company is not making money, its stock price will suffer as a result of markedly reduced demand. The earnings report is the market indicator that tells traders all about the company’s financials. Financial information is not just about profit or loss, but comparative analysis between present performance and past performance. For example, a company may be in a loss position, but if the loss position shows a reduction in losses when compared to previous reports, the stock price of that company may actually rise.

A good example of this is Research in Motion, whose 3rd Quarter report for 2012 showed that its loss position was actually better than what the markets thought it would be. So even though the company’s reports have been negative for some time now, the much improved Q3 figure gave markets some hope that there will be some improvement and RIM’s stock was up by 18% at pre-open. In addition, it is possible for a company to make profit and its share price go down. This usually occurs if the profits missed market expectations, or if revenues dropped. Two of the most important pieces of information that traders look for are the earnings per share (EPS) and Price Earnings Ratio (P/E ratio).

Company News: The death of a major figure, the appointment of a game changer or a healthcare company’s discovery of a vaccine or cure for a previously incurable disease, are all examples of news that can prove to be a major mover of a company’s stock price. There are news services that consistently dish out market information on a daily basis.

Acquisitions/Mergers: Mergers and acquisitions are always market movers, because they change market sentiment and expectations for stocks. The expectation is that a merger or an acquisition will change make an outlook more positive for all concerned, and it is always necessary for traders to look at the fundamentals of the participating companies in order to make informed decisions.

Strength of Market Peers

Market peers refers to other stocks that are listed along with a particular stock in a sector. In a typical exchange, stocks are divided into sectors. There is a phenomenon known as “guilt by association”. The collapse of Bear Stearns and Lehman Brothers dragged down almost all financial stocks with them in 2008. When banks like Wells Fargo released stellar Q1 results for 2012, nearly all banking stocks in the US markets had a great bullish run. So a trader can sometimes get into a stock if the sector that stock is listed is doing well. This is further buttressed by the fact that some sectors are subject to political decisions that affect every stock listed in that sector.

Guide to Short Selling

Short selling in the financial markets means borrowing an asset such as a stock from a broker to sell them at a high price, and then buying them back when prices have fallen so as to return the asset to the broker, and benefiting from the price differentials.

Short selling is used when there is an expectation that the price of an asset will fall within a space of time. Traders generally carry out short selling to make money from falling prices or they use it as a hedging strategy to protect themselves from fall in prices on assets in which they have long positions.

Short Selling as a Hedging Strategy

For instance, a trader may be long on an imaginary stock we shall call XYS, and he may then decide to short sell the stock options on XYS. The strategy is played in such a way that if XYS has a bullish run if the trader is long on it, and the short sale option is out of the money as a result, then the cost of the short sale loss will be far less than the outcome of the long trade on the stock. But if the price of XYS drops and puts the long position in a losing position, then the gains to be made from the short sale will far outstrip the loss on the long position on XYS. In this scenario, short selling XYS will act as a hedge trade.

Short Selling in a Falling Market

Traders can decide to employ short selling as a strategy to gain from falling prices, especially when the fall in prices is a systemic problem and not restricted to a sector or a single stock. This is why in the weeks following the collapse of Bear Stearns and preceding the collapse of Lehman Brothers in 2008 (the events that triggered the global financial crisis), traders massively engaged in short selling of stocks, especially those of the financial sector because they were all in a predicable free fall.

However, there is a very thin line to tread when trading a systemic fall in prices, because it gives room for spreading of negative rumours and when everyone is selling, it tilts the equilibrium of the markets. Regulators will always step in when this occurs, and we have seen bans on naked short selling at various times when there is systemic crisis. So if a trader wants to short sell as a profit strategy, then the best bet is to identify individual or sectorial assets based on technical and fundamental analysis, and short sell those assets with a bearish outlook.

Conditions for Profiting from Shorting

Short selling is an extremely risky strategy. If you are familiar with the collapse of MF Global, a financial services company that short sold the Euro in expectation of a fall in the value of the single currency in a massive bet that went horribly wrong, then you can imagine how risky the strategy is. A trader can lose a lot of money in an instant.

For a trader to be able to profit from short selling, the following parameters must be met:

1)    The trader must be able to locate an asset to use for short selling. To do this, the trader must have a trading account that provides enough margin for short selling, and also permits short selling.

2)    There must be enough liquidity in the asset to enable the short seller get buyers of the asset at the market price.

3)    The price of the asset in question must experience a price drop to put the trade in a profit.

4)    The trader has to be able to buy them back at a lower price.

5)    The asset in question must not be one restricted from short selling by the regulatory authorities.

Shorting Advantages

Short selling is a very good way to trade a bearish expectation for an asset. There are many emerging market exchanges that only permit stock purchases, and traders can only make money from bullish runs. Trading in these markets can be frustrating because opportunities to make money are restricted. But with short selling, a trader’s opportunities to make money even from falling assets are limitless.

A good example of a profitable short sale was that performed by George Soros’s Quantum Hedge fund which made more than $1billion in profit by short selling the British Pound in September 1992. Another trader who made money shorting a market is doctor-turned-investor Michael Burry, who made more than $600 million from short selling the credit default swap instruments on the US subprime housing market. Economists like Nouriel “Dr Doom” Roubini have regularly predicted periods of market crashes (he predicted the housing market bubble in 2005, long before prices began to tank), and such analyses easily form the basis for making huge profits from falling markets.

Short selling is also very useful for hedging and protecting profits. As was illustrated earlier in this article, short selling is a tool that allows traders to make up any losses incurred on the asset from unprofitable long positions. Many hedge funds who were long on stocks and stock markets used shorts to cover these positions and were able to use it to come out relatively unscathed when the cards came crashing in 2008.

How A Trader Can Make Money from Short Selling

A good target for a short sale would be an asset which is heavily overbought and whose fundamentals are not in tandem with its high prices. A good example of this was seen in an emerging market in Africa, where the breweries subsector was experiencing a massive price boom. There were questions over the state of health of some of the breweries whose stock prices were enjoying this sectorial boom, and a concerned investor decided to visit one of such breweries. He met overgrown weeds, a non-functional plant, a few workers and dilapidated structures. With this information, he quietly exited his holdings and within a short time, the information came out and the stock tanked. Such fundamental analysis is what is used to make informed decisions on what asset to short sell.

There are also technical indicators to consider. Is the asset forming a top or a bottom? There are several ways of identifying tops, bottoms, continuations and reversals on the charts. These can be used as a basis for short sale. A short seller would be looking to sell a market top or a bearish reversal pattern.

Issues

The market bias of traders is partly influenced by market news, some of which are facts and some of which are rumours. Nothing causes market panic more than negative rumours. Part of what fuelled the systemic collapse of global stock markets in 2008 was fake market rumours following the collapse of Lehman Brothers. Many traders would enter short selling positions in certain assets, then float negative rumours to force the asset price to tank so as to profit from these moves. From there on, it was a season of short selling which served to collapse the market further. You can get an idea of how this works from the film Casino Royale, where the villain of the movie tried a terrorist attack on a new-design aircraft hoping to profit from the collapse of the airline’s shares (which never happened thanks to 007).

This and other unethical practices led to a ban on naked short selling by many regulatory bodies across the world. Today, several degrees of restrictions on short selling are still in place. So if you want to practice short selling, you need to be conversant with the rules in your jurisdiction so as not to run foul of the law.

Day Trading Stocks

Day trading is a high-risk – and potentially high-reward – practice of buying and selling stocks over limited periods of time, such as during the same day, to take advantage of short-term price fluctuations. While risk will always be part of the day trading equation, the most successful day traders have the discipline to craft a plan and stick to it. By following a few simple steps, you can significantly increase your chances of turning a profit on your day trading activities.